Individuals and households often seek financial help to reduce their expense burden. In other words, people borrow money to ensure they have enough liquidity and then slowly pay it back, generally with some interest. The money that you owe someone is your debt.
You generally tend to borrow money to buy a home, a car, or even for day to day expenses. This means you either have an outstanding mortgage loan, auto loan, or credit card bills.
While borrowing money to achieve certain financial goals is a totally valid option, you should always be careful of the amount you are borrowing and ensure your income easily exceeds your expense.
According to the Bank of Canada, debt is a fact for most Canadian households. In Canada, household debt was around 170% of disposable income in 2019. In other words, the average Canadian owes about $1.70 for every dollar of income he or she earns per year, after taxes.
To manage this before the situation turns worse, here are some options to plan and manage your personal debt efficiently.
When should you look to borrow debt?
It is often true that no debt is healthy or if you borrow, you need to at repay your loans on-time. While debt has fueled the global economy for decades it has also engineered a couple of recessions including the financial crisis of 2008-09.
We can see that you need to maintain debt at optimal levels in order to benefit from the leverage it provides. While borrowing capital to buy a home makes perfect sense, doing so to trade in equity markets is an absolute stalemate.
According to Investopedia, if the debt you take on helps to generate income or increases your net worth, it can be categorized as positive debt. For example, when you want to buy a home, you will require a mortgage. This can be a good investment as the value of a house is likely to increase with time.
Similarly, when you want to buy a car, you may take a loan to pay for it. However, the value of a car depreciates over time and you need to consider if it makes sense to borrow and purchase a depreciating asset.
According to GetSmarterAboutMoney, student loans are one of the cheapest forms of loans, and investing in education is likely to pay off itself in a couple of years. However, borrowing to save towards your retirement is not also a viable option and carries certain risks especially if you invest in equity markets which is volatile in the short-term.
Among many great options, taking a loan to start your own business can be a good idea. Though it comes with a certain amount of risk, you have a pool of investors to choose from including banks, financial institutions, private equity investors, friends, and family.
Do not go overboard with debt
According to another report from GetSmarterAboutMoney, the amount of debt should depend on your monthly income. Always check your income and essential expenses to decide how often and how much can you afford to borrow and ensure regular repayments.
You can also take a look at your gross debt to service ratio also known as GDSR. This tells you the percent of your income that goes into your basic housing costs. If GDSR is higher than 32% then covering other expenses can be difficult.
You can take into account the total amount you will be borrowing and the interest you are going to pay along with the time you will need to repay the whole amount and analyze your decision accordingly.
Some institutions may also charge you a fine for paying off the loan early. And similarly, if you miss a payment, lenders can increase the interest rate by another 2% in some cases.
You should also check whether your loan is secured as the interest rate on secured loans are often lower than the interest rate on unsecured loans. But if you don’t pay back the loan, the lender has a legal claim to whatever you use to secure the loan. So for a mortgage, the home you purchase is the collateral for the debt.
Deciding the best borrowing option for you
After you have pictured every possible scenario from the above-mentioned points, here are a list of some borrowing options you can choose from that will help you meet your goals. You need to choose a borrowing option that is solely focused on your goal so you don’t end up paying more than you should during repayment.
- Bank Loans
- Home equity loan
- Borrowing from your RRSP
- Borrowing against your RRSP
Various banks and financial institutions provide these facilities, each at a different rate and for a different time period. Your credit card bills will usually have a monthly repayment deadline, while your auto loan will generally have a five-year repayment period and a mortgage loan can extend up to a period of 20 years.
Strategies to help reduce your debt
In order to reduce your debt, the first thing you can do is divide and track your income into two categories such as ‘needs’ and ‘wants’. If you are spending too much on the latter you should try cutting down and in case your income is less than your needs, it is time you take your debt seriously and seek professional help for it.
The next thing you can do is make a list of your debts depending on the interest rate you are paying. Then, look for alternative options that enable you to reduce your interest rate. For example, if you have a high-interest credit card debt, check if you can switch to a lower-interest card.
If you cannot switch to lower interest rates, start paying your debt with the highest interest rate first. You can also try to pay more than the minimum monthly payment so the time required to pay the debt reduces which will also reduce your total interest payments.
A simple trick you can follow to reduce your debt burden is that you can look into a low-rate consolidation loan where a home equity loan and a line of credit are two common options.
Is your debt unmanageable?
If your debt is unmanageable, hiring a financial planner with experience in managing debt should be considered. You may work with credit counselors to determine if the consumer proposal or bankruptcy process would be of help to you.
You may have to deal with a debt collection agency too that recovers unpaid debts if you don’t make your payments on time. When an agency contacts you, you don’t have to panic but work out a plan with them that will enable you to pay your debt and get the agency off your back.
In such situations, finding a Licensed Insolvency Trustee (LIT) may help you to make informed choices to deal with your financial situation.